Output Gap heading toward Contraction

In this effective demand research, I calculate the output gap by comparing capacity utilization to the effective labor share.

You will see a graph to the right on this blog where that value is update. The graph is called, ED Output Gap.

In the past, the output gap reaches a peak between +$100B to +$200B before heading into a recession. The current calculation is doing the same. Yet the recent steep decline in the output gap would normally signal an economic contraction is near.

Are we that close to a contraction?

Comments

[JimH]

Edward,

Your 'ED Output Gap' chart is very interesting and it raises a few questions.

If I move the 'Real-Real' graph y axis over to the left side then I get a graph where 'ED Output Gap' more closely matches your graph above.

Before 1990 those two measurements seem to track with each other. When one goes negative, the other goes negative with only a slight possible delay.

After 1990, Real-Real goes negative and stays negative while the ED Output gap goes positive and stays there until about Q3 1998 when their paths actually cross.

What caused 'ED Output Gap' to recover back to positive when the 'Real-Real' gap remained?

Viewed separately, TCU went up and Labor Share actually went down. But what brought that on in the mid 1990s? The shock value of NAFTA becoming law?

Then in Q2 2002, 'Real-Real' peaks positive as 'ED Output Gap' has already began a negative move which will reach peak negative during the 2002 recession. I believe that this is the DOT.com bubble.

The recovery of 'ED Output Gap' began in Q4 2001. But the recovery of 'Real-Real' does not begin until Q1 2003 and only very briefly goes positive in Q1 2006, before going back negative. And 'Real-Real' has stayed negative ever since 2006. I believe that the difference between these two indicators is due to the massively increasing consumer borrowing during the 2000 to 2007 time period. TCU could increase while Labor Share was steadily decreasing. (As long as the housing bubble was growing.)

Then by Q4 2007 the housing bubble popped and the growth in total household debt very quickly faded. (In Q4 2008 total household debt began to decrease.)

'Real-Real' has stayed negative since Q1 2006 and when 'ED Output Gap' turned negative the Great Recession began. (As new total household debt was stalling.)

TCU has been moving negatively since November 2014 and Labor Share has been increasing but it is still low.

The economy is now completely dependent on Labor Share to drive consumer spending and Labor Share has not been growing fast enough. Stating the obvious, the creation of low wage, part time jobs has not been good enough to return our economy to health.

Currently 'Real-Real' has reached a new positive high in Q3 2015 and turned negative again. (While remaining negative overall.) And 'ED Output Gap' had gone negative in Q1 2016.

Combine this with the Industrial Production Index indicating a recession and we have two indications of a recession which began in Q1 2016.

I believe that the government will have to revise their Q1 2016 numbers for the worse. Or they can cook the books.

[Edward Lambert]

Hi Jim,
There are two types of "potential". Type 1 is looking at all the labor and capital resources and productivity, then seeing what is greatly potential.
Type 2, my way, is looking at the first type and seeing a limit that will block the economy from reaching that great potential of type 1. Then realistically potential has to exist under that limit of type 2.
There are times in the past when my model would have seen more potential (type 2 greater than type 1). And times when my model would have seen less potential (type 2 less than type 1).

But for most of the data, I have seen type 2 less than type 1 because I see a limit within type 1.

My model shows a much more consistent pattern through the business cycles, which implies that type 1 has a big error in it. It is missing the effective demand limit.

[JimH]

Edward,

I don't believe we have a disagreement about what 'ED Output Gap' represents.

I am merely noting that when 'ED Output Gap' goes negative it apparently means that a recession is beginning UNLESS 'Real GDP' is about equal or higher than 'Real GDP Potential'.

And those exceptions are probably caused by some unusual economy activity such as the DOT.com bubble or the Housing bubble and the associated debt. Those are probably the times which you say "implies that type 1 has a big error in it." (Money created out of thin air due to increasing debt, and actually spent into the economy.) Of course eventually that debt must be repaid, which reduces money in the economy. That is probably why 'Real GDP' is currently so much lower that 'Real GDP Potential'. That reduction of the money supply or the historically low Velocity or a combination of both.

Another exception could be when the price of oil fell dramatically from about 1980 to about 1986. That was like a tax free increase in consumer income. (Although the FED generated recession in 1981-1982 muddies the waters somewhat.)

But currently, 'Real GDP' is lower than 'Real GDP Potential'. There is nothing putting large sums of money into the economy or into the hands of consumers outside of income.

[Edward Lambert]

Jim,
I hear you... does the most recent data imply an imminent recession? I think within 4 quarters yes, when I look at past patterns.
Income is key. It is the only and best way to put money in the hands of labor consumers.